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How Working Capital Loan Works: The Common Questions

Liberty Capital Group | Small Business FundingSmall Business AdviceHow Working Capital Loan Works: The Common Questions

Mar

27

How Working Capital Loan Works: The Common Questions

There is much more to a business than product development, promotions, and customer service. In order to ensure that your business is able to survive, you require working capital. This is because every business requires cash to carry out its day-to-day business. It doesn’t matter how many account receivables you have if you don’t have enough money to carry out your daily operations. Without this, the survival of your business is bound to get difficult.

The importance of working capital is further enhanced when your business is in its initial stages. During the startup phase, most companies exhibit a negative net working capital (money goes out faster than it comes in). At such a time, you might want to consider applying for a working capital loan.

What is a working capital loan?

If you are aware of the concept of working capital, you can easily deduce what a working capital loan is. For those of you who are unaware. A working capital loan is a short-term loan that aids in the financing of the daily operations of your business. Along with being short term, another quality of a working capital loan is that the amount you apply for is decided according to the daily cost of running your business.

When it comes to the term of these loans, they are seldom long-term. Mostly, they are taken to pay for account payables and daily wages. Not all companies find themselves requiring such loans. Mostly startups and companies that experience cyclical sales opt for working capital loans. For the latter, such loans help them out at times when business activity is slow.

How much working capital do you need?

Before you apply for a working capital loan, it is essential for you to know how much working capital you need. Unlike traditional bank loans, these loans are of low denominations and are taken according to your working capital requirement. This makes sure that you have enough cash to cover the expenses and short-term debts.

Whether or not you will have a problem regarding working capital and hence require financial assistance can be measured through the working capital ratio.

A working capital ratio is measured by dividing your current assets with your current liabilities. In an ideal scenario, you should have enough current assets to meet your obligations. In terms of working capital ratio, a ratio between 1.2 and 2.0 suggests that a company is financially healthy and capable of paying its debts and expenses. However, if the ratio comes out to be less than 1.2, it means you are in need of a working capital loan. Similarly, if the ratio is more than 2, it shows that you have too much asset lying ideal. This showcases that you are not investing enough and hence are not likely to grow.

This equation helps in choosing how much working capital to borrow. Aim for the desired ratio (between 1.2-2.0), and divide it by your current liabilities to see how much current asset you should currently possess. Then proceed by deducting your available current asset. The amount that is left is the amount you must borrow.

Why get a working capital loan?

There are various reasons why you should get a working capital loan. These reasons are derived from business and industry needs.

Here are a few of the major instances when you might require a working capital loan:

When your cash flow is inconsistent

This is one of the most basic reasons why you might need working capital loans. Just because you are making sales doesn’t necessarily mean that you are getting a steady stream of cash. This is because most transactions these days occur on account receivables and payables. Therefore, your customers might take time in paying you, which creates a cash flow void. This is further enhanced by the nature of inventories. Generally, inventory turnover takes time. Both these factors combined are likely to leave you with a negative cash flow. By applying for a working capital loan at this time, you can make sure that you have a consistent and positive cash flow.

When your sales fluctuate seasonally

Now, this might not occur in every industry. However, certain businesses are marked by seasonal fluctuations. For example, a local company that sells summer wear features high sales in summers and a significant drop in sales in other seasons. However, the day-to-day operations need to be carried out regardless of these fluctuations. In these instances, working capital loans come in handy when your sales are not enough to meet your daily expenses. You can also use these loans to prepare yourself for high-sale seasons.

When you need to grow

If you get too caught up in meeting day-to-day needs of your business, you might overlook opportunities for growth. This is especially true for startups. By using a working capital loan, you can ensure that you are able to take care of your short-term obligations. This leaves you with enough cash and energy to look for growth opportunities.

Moreover, you can also use the funds acquired for the realization of these opportunities as well. Whether it be purchasing equipment, training employees or investing in customer service, you can use your working capital loan for it all. While previously you may have been unable to take projects onboard that yielded slow but fruitful payoff, with working capital loans you can. This is because by taking these loans, you are no longer worried about making ends meet.

When you need to be ready for the worst

Having a cash cushion is always a good idea. You should have enough cash on you to make up for sudden expenses. This doesn’t mean you should have a lot of cash. After all, ideal cash signifies a loss of profit you would have earned had you invested it. Still, having enough cash to deal with unexpected expenses is crucial. Working capital loans deliver such cash cushions.

What are the types of working capital loans and how do they work?

Now that we have established what working capital loans are and when you might need them, the next question you might have is how such loans work. Remember, working capital loans is an umbrella term. It is used to describe a wide variety of loans.

Here are some of the most popular types of working capital loans:

Small Business Administration Loans (SBA)

SBA refers to a government organization that offers small business a wide variety of loan programs. The best SBA program for working capital is 7(a). Unlike most other loans, this program does not require you to have collateral. This comes with a catch though. As they are government loans, they may or may not be offered by your country. Even if they are, it is very difficult to qualify for them.

Installment Loans

Installment loans are more commonly known as term loans. You can view these as being traditional bank loans. After you qualify for it, a given lump sum amount is given to you in one go. You are then required to make fixed and regular payments to the bank. The payments you make include the original loan plus the interest charged.

If you are a small business or a startup, we would advise you not to opt for these loans. This is because compared to other options available, installment loan features high denominations, terms, and a long application process.

Lines of Credit

This is one of the best ways to get your hands on enough cash for working capital. Line of credit loans provides you with a maximum amount of credit line. Until you reach that amount, you are free to draw cash from this line whenever you please. This complements the working capital needs of most businesses. Once you reach the maximum limit, you are required to pay off the debt and then you can start from scratch all over again.

Lines of credit are the best form of working capital loans because they meet various needs. For example, they deliver a consistent cash flow. They also provide you with extra cash that ensures that you are cushioned against unanticipated expenses.

Invoice Financing

This working capital loan is mostly used by startups that require a timely inflow of cash and can’t wait for their clients to pay them. This loan revolves around the idea that you can’t realize your account receivables regularly. To combat this problem, you can choose invoice financing.

Here, your unpaid invoices are treated as collateral. While you get the money you need, the terms of repayment are usually short-term. Also, you are required to pay a premium for the enhanced speed you are provided with.

Short-term Loans

A short-term loan is starkly similar to an installment loan. Just like an installment loan, you are given a lump sum amount which you pay back at regular intervals. However, this is where the similarities end. While an installment loan charges interest which varies according to the amount you borrow, a short-term loan requires you to pay a fixed fee.

Since working capital is a short-term need in nature, short-term loans are an excellent option to choose. Compared to long-term loans they are easy to qualify, further increasing their popularity among small business owners.

What to ask yourself before you get a working capital loan?

There are a few questions that you must ask yourself before you apply for a working capital loan. They include the following:

Is a loan your only option?

At the end of the day, you should go for loans only if there is an absolute necessity for them. If you can take care of your cash flow problems in some other way, it is always advisable to do so. This is because working capital loans come at a cost of repayments and in some cases interest as well.

How do you plan to use the money?

Make sure you have a detailed plan about what you wish to do with your working capital loan. If you don’t do so, you might end up spending the money on things that do not help in growing or stabilizing your business. Hence, before you opt for a loan, analyze your need and plan how you wish to use the cash acquired to meet the need.

Do you know what lenders want from you?

Before you walk through the doors of the bank, you should be ready with the items that your lender expects from you. These expectations vary depending on the type of loan and platform used. For example, some might ask you for a business plan or a good credit rating while others will be satisfied merely by a bank statement.

Will the loan truly help you?

No loan should be taken for the sake of it. It should help in improving your financial situation. If it doesn’t, you must ask yourself if the repayments and interests are worth it. Make sure that you can afford to repay your loan. If you are not and you take a loan, you might be negatively affecting your credit rating. This in turn might affect your ability to get a loan in the future.

Do you understand the cost of a working capital loan?

Don’t ever go into a decision without knowing what you are getting yourself into. It is not just the amount of loan that you have to pay back. Instead, you are required to make additional payments as well. Are you well aware of these costs? Whether it be interest rates, APR, or fixed fee, ensure you are aware of them all.

Conclusion

Make sure you choose the best working capital loan for you. Also, make effort to ensure you do so from a quality lender. Do your research. Analyze your financial health and needs carefully. Make a choice accordingly. Working capital is highly crucial for the sustainability of your company. Don’t let it become an obstacle for you. Your business has the power to grow. All you need to do is make wise decisions.

How Working Capital Loan Works: The Common QuestionsGilmar 6:59 am April 25th, 2018

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